When Is An Inflation Hedge Not An Inflation Hedge?

When is an inflation hedge not an inflation hedge? When it costs too much is the simple answer. Investment professionals warn that the cost of hedging against inflation in a number of the world's most developed economies has reached such high levels in recent times that putting such hedges in place will inevitably result in wealth destruction rather than wealth enhancement. But maybe the answer is not so simple after all.

As the debate continues over whether the world faces an inflationary or deflationary environment in the short- to medium-term, the arguments in favour of hedging against inflation are crystal clear to anyone who remembers its trajectory in the mid-1970s.

The advantages of an inflation hedge are not, however, necessarily so obvious to more recent arrivals in the financial services industry who might struggle to come to terms with the notion that ultra-low central bank rates are a historical blip rather than the norm. Consensus, and experience, suggest that they will surely eventually find that interest rates and inflation can go up sharply and unexpectedly as well as flatline for years at a time.

PIMCO, renowned for its bond management capabilities,

sees inflation falling in the US, UK and Europe in the short-term, says real return product manager Berdibek Ahmedov. “Looking out further we think inflation will be a risk especially in the US and the UK where the central banks are hellbent on reflating the economy via QE and other stimuli.”

Michael D Billy, managing partner at Florida-based Econophy Capital Advisors, agrees that inflation lurks just around the corner, for essentially the same reasons. He also concedes that the wholesale destruction of liquidity in recent years represents a significant counterbalance to this threat. 

 “It could go either way, depending on the European sovereign outcome,” says Laurens Swinkels, a portfolio strategist in the investment solutions department at Robeco Investments in the Netherlands. “For what it's worth, we expect inflation of around three per cent a year over the next five years, and we would suggest that around five to 20 per cent of a pension fund's portfolio should be in linkers to help compensate.”

Swinkels addresses the subject in some detail in a just-completed and yet-to-be-published research paper under the banner of the Erasmus Research Institute of Management, Erasmus School of Economics. In it he challenges, inter alia, the view that linkers have become less important in recent years, and comes down strongly in favour of investment in them as one of the few assets that provide direct protection against inflation.

The results of his research indicate that for most countries, inflation-linked bonds expand the mean-variance efficient frontier for investors that hold nominal bonds and equities, he says. Hence, investors should allocate part of their investment portfolio to inflation-linked bonds. This result holds in a nominal framework with a monthly holding period.

“We also indicate that inflation-linked bonds are better hedges against realised inflation than nominal bonds. Hence, for long-term investors with goals in real terms, inflation-linked bonds would likely be even more attractive. Our results also suggest that governments that have not issued inflation-linked bonds may consider doing so in order to provide a valuable asset class to investors.”

Alessandro Ghidini, in-house inflation-linked bonds specialist at Swiss & Global Asset Management, identifies three key questions to ask when assessing the attractiveness of the asset class.

The first focuses on the economic fundamentals of the country in which it is proposed to invest, in particular its debt profile and how that is likely to develop over the next few years. The second is on valuation; asking whether likely positive developments have already been priced in. The third is what protection do the bonds in question provide against inflation? “What is the real yield?” he says. “If you can buy inflation protection, how much will you pay for it? In the US and the UK, for example, investors are even accepting negative long-term yields, which can lead to wealth destruction. The real yield is too low.”

This is a reflection of the crazy times we live in, according to Michael D Billy. “You have to take your hat off to Treasuries and banks for selling protection against inflation that doesn't protect you against inflation,” he says.

After assessing the answers to all three questions, Ghidini concludes that inflation-linked bonds in emerging markets can offer a compelling opprotunity for financial institutions. Fundamentals are strong, the debt profile looks good and real yields of around 3.5% are available. “That is a very powerful combination that you don't currently see in the developed world. Markets are not pricing in excess levels of inflation over the next few years in the emerging market world; this is the best part of the cycle to buy inflation protection there.”

Daniel Loughney, portfolio manager, fixed income, at AllianceBernstein, sketches in three views of inflation and yields, based on history, current forecasts and the medium- to longer-term outlook.

By historical standards, inflation-linked bonds look expensive when it is unclear whether we face a deflationary or inflationary environment. Against this backdrop, current forecasts also suggest that the premium for inflation protection looks expensive. But, he suggests, there is a reasonable risk that the authorities in certain countries will overplay their hand and that inflation could accelerate meaningfully. “If that happens, you might want to have bought some,” he concludes.

A version of this article appeared in the Financial Times FTfm weekly supplement